How'd They Get Too Big To Fail In The First Place?

Time for me to speak up, not one of you gets it.

Today, you're all going to learn about the Social Engineering Project that directly led to the credit bubble and that is not being addressed in the finance reform discussions at all.

So, I just read about 3000 different articles, op-eds, blog posts, comments on blog posts etc. concerning Obama's "New Regulations"...

And you're all off the mark.

No one seems satisfied with the new reg's and rightfully so.  But not one commentator seems to get the real crux of the problem (although there have been some great criticisms).

All the commotion about "Why aren't the ratings agencies being taken behind the woodshed," and "How could the Federal Reserve get expanded powers" is just a distraction.  These are just peripheral issues.  The bloggers and journalists railing about that stuff are missing the forest for sure.

The real issue that has not been addressed is this:

How were these banks able to
grow Too Big To Fail in the first place?

That's it guys, it's that obvious.

Let's keep this really simple.  In the mid 90's, the regulators that police Wall Street had their hands full with a infinite amount of brokerage firms, investment banks, not to mention banks that were beginning to morph into either or both of those things.  There were tons of smaller shops popping up to make markets in stocks, bring stocks public, trade debt, and most importantly, to satiate the Boomers' Peter Lynch-fed appetite for stock buying.  The Boomers were just coming into the prime earning phase of their life cycle and the investment cash was pouring in over the transom for stocks and bonds.

As an unfortunate side effect of this bonanza, there were numerous boiler room operations and unscrupulous firms that slithered out from under their rocks to take advantage of the rise of this new generation of investor.  Abuses were rampant; shady IPOs were launching left and right, customer accounts were churned, people were lied to and stolen from, market makers were skimming 1/8's and 1/4's on trades and so on.  There was even Mafia involvement at some of these firms.  The larger firms were no angels either.  They were pulling the same bullsh#t as the boiler rooms but on a larger and thus more acceptable scale.  They had Ivy League analysts pumping their inventoried stocks with sell-side research instead of Vinny the ex-Nightclub Bouncer using the telephone.

When you Steal Big, you can afford to run the warm and fuzzy commercials and hire the lawyers that make you look different from the small time operators, even if the game you're running is exactly the same.  But I digress...

Anyway, these abuses at some of the smaller firms went on for long enough that the SEC and FINRA's predecessor, the NASD, decided they'd had enough.  And that's when the Social Engineering Project was born that has ended up causing about 1000 times the damage compared to what it was designed to prevent.

By social engineering project, I mean the fact that the regulators basically made it so that the large firms, whom they were comfortable with, were the only ones who could be large.  This was accomplished by making sure that all new regulation would be aimed at policing and harrassing smaller shops or at least favoring those large (read: wealthy or connected) enough to adapt.

Bear Stearns, Lehman Brothers, Goldman Sachs, Merrill Lynch, Smith Barney, Morgan Stanley were the Chosen Ones.  They were the anointed, and as such, they were left to their own devices to grow like weeds while the regulatory bodies pursued the small potatos guys.

The big firms doubled and tripled in size over the ensuing 10 years with this quasi-mandate from their overseers and entered virtually any business they wanted to.  The smaller firms spent the same period of time struggling under a regulatory burden that seemed to get more onerous and draconian by the day.  As a result, they could hardly keep up, let alone become serious competitors to the Chosen Few in order to keep everyone honest

For an analogy, imagine if the FTC decided to foster an environment where Target and Wal-Mart were secretly favored even more so than they are now, to the point where new rules and regulations would be passed that only they had the financial flexibility and wherewithall to comply with.  And you thought the Mom & Pop stores were hurting now?  This type of atmosphere would put the rest out of business overnight.

But the difference here is that the regulating authorities who monitor the retail sector don't have a loathing and disgust for their own quarry.  That's why this doesn't happen, and as a result, small retailers can grow up to become mid-sized and then large retailers without being hassled, fined and fatigued to the point of surrender or exit.

Now of course, there were some fines and regulatory snags for the Merrills and Morgans along the way.  But the dollar figures of the fines were a joke when looked at in the context of how large these firms had been allowed to get. 

Eliot Spitzer's bigshot Billion Dollar Settlement from Wall Street?  The one that made him Governor of NY State?  It was laughable!  It was split up amongst a bunch of firms who had made TENS OF BILLIONS pumping new issues with BS ratings (sound familiar?).

The Chosen Firms expect to pay fines here and there.  They reserve for them!

Think about this question: If Credit Suisse's Frank "clean out those inboxes" Quattrone had been running his Friends of Frank tech IPO scam at a smaller firm, would his firm still be in business?  What about Smith Barney's Jack Grubman, a telecom analyst who was in actuality running the banking department, literally promising positive coverage in exchange for fees from the companies he followed.  How about Merrill Lynch's L'affair du Blodget?  They actually had emails from management forcing analyst Henry Blodget to keep high ratings on stocks the analyst didn't feel deserved them!

The mutual fund market-timing fines were a meaningless slap on the wrist as well...you could just hear the clink of the glasses as the bankers toasted each other and cackled at the minute dollar amounts involved...they practically didn't even register on that quarter's earnings report;  You fine a Bank of America $15 million, you're basically taking less than what they spend on pencils.  No wonder they learned nothing.

Even in the case of the more recent auction rate securities scandal, the large firms walked away with a fine and a warning.  Smaller firms who had pumped these products as cash alternatives would have faced dismissal from the business, not just monetary penalties.

If any of these scandals had transpired at a smaller firm, that smaller firm would no longer exist, it's employees - complicit or not - would be ostracized, it's executives would be barred, there would basically be a smoking crater where that small firm had been.

So now it's 2002, Greenspan has dropped rates to compensate for the Dot Com meltdown, the 9/11 attacks and the Enron/ Worldcom scandals' effect on market psychology.  Who is in the perfect position to grow explosively as a result of this cheap money?  You guessed it!  The annointed large investment banks and the money center banks who wished they could be more like them.

And while trillions and trillions of dollars were being sucked into the largest pump-and-dump scheme in world history between 2002 and 2007, the regulators and their contribution-hungry politician friends (from both parties) ignored it.

The regulators also ignored the hedge fund industry's mushrooming, presumably because they were "comfortable" with this group of Ivy Leaguers from Connecticut as well.

The social engineering project continued full speed ahead.  The major wirehouse brokerages and investment banks were now irreplaceable institutions, who had become so interwoven into the fabric of every part of American business and life that they'd finally and officially become Too Big To Fail in the eyes of DC.

This is what happens when you take an industry and enforce unequally against the smaller players who are easy to bully and drive out.  You end up creating a monster like a Bear Stearns or a Lehman, a firm that is given free reign to take over the world and answer to no one.

Too Big To Fail - BY DESIGN!

And so what began as an experiment to remove the firms that the regulators weren't chummy with or were little scams became a forbearance program for the big boys which allowed their tentacles to spread globally, completely unmolested.  By the time we learned that those tentacles were attached to a risk-gorged octopus, it was too late to talk moral hazard with a straight face, the system itself was already collapsing.

We had created a regulatory environment that was overly concerned with rooting out 10's of millions in fraud in the shallow end of the industry but we ended up with trillions in losses and a global mega-failure instead.

So yeah, the ratings agencies should be censured and the Fed shouldn't get more authority, but these quibbles are a sideshow to the real questions:

Will we end the social engineering project that led to Too Big To Fail?  Will we allow small financial firms the space to offer choice and to stunt the metastasizing of the bloated few?  Will the powers that be stop erecting regulatory barriers of entry on behalf of the the major firms?

Because if not, there will surely be another boom and subsequent bust in another arena and the Usual Suspects will have once again put themselves in the position where their demise cannot be survived by the rest of us.

My message to the financial industry's regulators, who I am rooting for now to get it right for all of our sakes, is this:

Let's regulate fairly and evenly, not just for the benefit of the larger and already-established banks and investment firms.  They are far less trustworthy than you've been led to believe, especially when left unchallenged.

OK, that was like 1500 words...I'm gonna to go have a chocolate milk now.

Full Disclosure:  The opinions expressed above are my own and are not those of any other person, entity or company. 


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